The 2005 fiscal budget speech by the Minister of Finance, Mr. Geir H. Haarde, presented to the Althingi, October 5, 2004.

The budget speech

of the Minister of Finance, Mr. Geir H. Haarde,

presenting the 2005 fiscal budget to the Althingi, October 5th 2004

Mr. President

I herewith present the 2005 fiscal budget to the Althingi and wish to discuss the main points of the budget’s emphasis and underlying assumptions at the same time as I am outlining my Government’s fiscal policy. The charting of economic policy is of particular importance in light of the large power project and aluminium plant construction that currently are going on which demand a responsible and resilient economic management.

The Icelandic economy is expanding rapidly in most areas and there is every sign that this expansion will continue over the next several years. Prospects are that real GDP will rise by roughly one-fourth in the years 2003 to 2007 and that real household disposable income will increase by 15 per cent. Inflation should stay within the limits set by the Central Bank and there will be a healthy increase in employment. The power project construction activity will do much to determine the rate of growth, as will also private consumption and residential construction. In light of these circumstances it is important to apply fiscal policy so as to counter the expansion in domestic demand over the next two years, when power project construction activity is at its peak.

The 2005 fiscal budget reflects these concerns. The revenue surplus is estimated at 11 billion krónur, equivalent to 1¼ per cent of GDP. This surplus exceeds the estimate for this year by 3½ billion and the result for 2003 by 17½ billion. I wish to call special attention to the fact that no assumptions with regard to revenue from asset sales have been made at this point, in addition to the fact that the first steps in cutting taxes will be taken next year. The improvement in Treasury finances is thus on one hand due to expanding economic activity which returns greater revenue to the Treasury and on the other hand due to increased expenditure restraint. The improvement in Treasury finances thus reflects a considerably tighter fiscal stance.

For the second year in succession, the Government presents its fiscal policy intentions for the next four years. Such policy formation strengthens the stance of economic policy and contributes to stability in the economy. The core of such a medium-term policy is to apply fiscal finances in a strong and determined manner to restrain domestic demand at a time when power-intensive construction activity is at its peak, and in turn stimulate economic growth upon their completion. The main elements of fiscal policy in 2005-2008 are as follows:

• A tight fiscal policy will be pursued. The annual growth in public consumption should not exceed 2 per cent in real terms. Central government wage costs should not increase in excess of wage costs in the competing sectors of the economy. Transfer payments should not increase by more than 2½ per cent a year in real terms.
• Central government investment will be cut by 2 billion krónur in 2005 and another 2 billion in 2006. Investment will be increased again by 2 billion in 2007 and a further 2 billion in 2008.
• Major tax cuts will be implemented in 2005-2007 and priority will be given to certain expenditures, in accordance with the Policy Statement of the Government.

Such a policy calls for the utmost restraint in fiscal finances, in current expenditures, both in wages and salaries as well as in other current outlays. The same may be said for transfer payments that have increased sharply in recent years. It will also be necessary to cut government investment over the next two years when power project investments are at their peak. Government investment will be increased again in 2007 and 2008 when economic growth is expected to slow down.

A tight economic policy is not only an important precondition for economic stability over the next several years but it is also of the utmost importance for the tax cuts as promised in the Government's Policy Statement. In light of economic prospects and the timing of power project investments, the intention is to let the main impact of the tax cuts take place in 2007. The first phase of the cut in the personal income tax is expected to take place next year when the tax rate will be reduced from 25.75 per cent to 24.75 per cent. The personal and company net wealth tax will be abolished in 2005 and take effect at the time of the tax assessment in 2006. The second phase of the income tax cut will become effective in 2006 when the tax rate will be cut again by 1 per cent, to 23.75 per cent. The final and largest phase will be implemented in 2007 when the tax rate will be reduced by 2 per cent, to 21.75 per cent. With these changes, the personal income tax will have been reduced by 8 per cent from 1997, from 29.75 per cent to 21.75 per cent, or by more than one-fourth. The intention is to pass all of these changes into law during the autumn session of the Althingi. Furthermore, the value added tax will be reviewed in accordance with the Government's Policy Statement.

There are sound reasons for the tax cuts

Before going any further, I should like to comment briefly on the firm intention of the Government to devote a part of the Treasury surplus over the next several years to tax cuts. There are those who have criticised these intentions and said that they are untimely and that the tax cuts could fuel domestic demand. I strongly disagree with these views. On the contrary, I believe that a part of the surplus should be devoted to tax cuts to let the people of this country enjoy a part of the substantial Treasury surplus. I find it most strange how quick some people are to criticise the Government's proposed tax cuts before they have even seen the actual proposals and how they interact with other aspects of Treasury finances, especially the expenditure side.

As in so many other instances, it is necessary here to look at the total picture of fiscal developments over the next several years. The Government's decision to devote considerable sums to tax reductions is taken after careful deliberation, having reviewed all aspects of economic developments, especially how the growth in government expenditure may be restrained. A large number of expenditure items have been carefully scrutinised in order to economise and improve efficiency. This is clearly reflected in the total sums of the fiscal budget which show that expenditure will remain unchanged in real terms between 2004 and 2005 and decline in relation to GDP from 32.2 per cent to 30.8 per cent. This will continue in 2006, when the expenditure ratio will decline further still, down to 29.8 per cent of GDP. And what will be the effect of all of this? Will the tax cuts set off an economic spiral as some have predicted? Not if the forecasts of the Ministry of Finance are to be believed. And I think that no one has doubted that the forecast is assessing economic prospects in a credible manner. On the contrary, the conclusion is that the tax cuts can be realised without upsetting economic stability. If the conclusion had been different, such decisions would of course have been revised.

I believe this is exactly the right time to continue on the path of tax reduction that the Government parties have marked in recent years, both during this term of office and in the previous one, when taxes were cut, both for individuals and businesses. As I mentioned before, the personal income tax was substantially reduced in 1997-1999, or by 4 per cent. The corporate income tax was cut from 30 per cent to 18 per cent in 2002. The net wealth tax, both of individuals and companies, was cut in half in the same period. The inheritance tax was cut in half this year, and the first step in abolishing the personal income surtax was also taken. Now it is the turn for the next steps in reducing the personal income tax and the abolition of the net wealth tax altogether.

The main conclusion of the medium-term projection of fiscal finances is that the economy will continue to be stable in spite of increased power project construction activity and increased domestic demand, the latter being partly due to changed circumstances in the housing market. Economic growth is forecast to be pronounced in 2005 and 2006 but is expected to slow down in the next two years thereafter. The construction of the power projects and aluminium plants will inevitably lead to a considerable current account deficit, since about half of the deficit is directly attributable thereto. The deficit is expected to decline sharply, once the construction projects have been completed and aluminium exports begin. Inflation may be expected to rise by a small margin when the construction activity is at its peak and decline again when they are completed. Real disposable income is expected to increase substantially, and unemployment will decline sharply in the first half of the period. The rise in disposable income will slow down in the latter half of the period, and unemployment may be expected to rise slightly. The Treasury surplus is expected to be substantial when the construction activity is at its peak in 2005-2006, equivalent to 1¼ per cent of GDP. Treasury debt will decline at the same time. According to the medium-term projection, the Treasury will incur a deficit in 2007 and 2008 when national expenditure is forecast to decline and economic growth will slow down.

Medium-term projections of fiscal finances should be viewed with a certain reservation. It is also important to bear in mind that this projection includes no assumption regarding the sale of Iceland Telecom. This is done in order to project fiscal finances on the side of caution, as should be done in projections of this kind. It is however probable that Iceland Telecom will be sold during the present term of office, either as a whole or in part. This would return considerable sales revenue to the Treasury and provide and opportunity for reducing debt in excess of what is already planned. The annual interest cost of the Treasury could thereby be reduced considerably which in turn would improve Treasury finances. All told, it must be seen as likely that fiscal finances will turn out better during the projection period than has been outlined here.

Mr. President

Let me no address the highlights of next year’s fiscal budget.

For 2005, the revenue surplus is estimated at 11.2 billion, a slightly higher amount than is estimated for the present year and a considerable reversal from the 2003 outcome. The improvement in the Treasury surplus is attributable to increased revenue in concert with expanding economic activity at the same time as expenditure is restrained. Expenditure is being cut by 3 billion krónur below the baseline estimate which is in accordance with the Government’s medium-term fiscal strategy. The financial surplus will not strengthen as much, since cash from operations is lower in 2005 because large issues of savings bonds, including accumulated interest, will mature during the year. This will mean that interest expenditure on a cash basis will increase in excess of expensed interest on an accrual basis. The financial surplus is therefore expected to amount to 4 billion in 2005.

The revenue estimate for the 2005 budget is based on the Ministry’s forecast of main economic aggregates, that economic growth will continue to be high and stable. A growth of 5 per cent is forecast for 2005, an inflation rate of 3½ per cent, that private consumption will increase by 5 per cent and real per capita disposable income by 3¼ per cent. On this basis, Treasury tax revenue is estimated to increase in excess of 6 per cent and amount to more than 280 billion krónur. Total Treasury revenue is estimated at close to 306 billion, an increase of 16 billion from the 2004 estimate.

Total Treasury expenditure is estimated at 294.6 billion in 2005, an increase of 12 billion from this year’s estimate. In real terms, expenditure is virtually unchanged from this year. Expenditure on current operations are expected to increase by only ½ per cent, mainly because a 1 per cent cost-efficiency demand is imposed upon most government agencies. Expenditure on investment and maintenance declines in real terms by close to 9 per cent, mostly on account of a postponement in investment of 1.9 billion krónur. Finally, the Treasury’s interest expenditures decline by 1.4 per cent in real terms between years.

…which confirms increased restraint in Treasury expenditure

The scant increase in Treasury current expenditure along with a cut in investment reflects increased expenditure restraint. The budget cuts of 3 billion in expenditure from the baseline estimate. The medium-term projection published with the 2004 budget foresaw a 3 billion postponement in investment expenditure in 2005. This has now been revised down to 2 billion in light of the level of employment in the economy. A total of 2 billion in investments will be postponed and other expenditure will be cut by 1 billion. Of the 2 billion in investment, 1,900 million of roadbuilding will be postponed and 100 million in the renewal of cultural buildings. The cut in other expenditure is due to a 1 per cent cost-efficiency demand on government agencies other than the two large hospitals, in Reykjavík and Akureyri, and also excluding the operation of nursing homes. This measure is expected to lead to a saving of 800 million krónur. Finally, interest rebates will be cut by 200 million krónur to 95 per cent of assessed rebates, as calculated under present law.

If the intentions of the 2005 budget are realised, the total financial surplus from 1998 to 2005 will amount to 68 billion krónur. This surplus is being used to strengthen the Government Employees Pension Fund, the Treasury’s balance with the Central Bank and for the reduction in Treasury debt which has been reduced by nearly half since 1995. Total Treasury debt has declined from 51.2 per cent of GDP in 1995 to 27.6 per cent according to the 2005 budget. Net Treasury debt declines from 34.3 per cent of GDP in 1995 to an expected 17.2 per cent in 2005. The sale of Iceland Telecom will provide an opportunity to reduce debt still further. A lower debt leads to lower interest payments. If debt had remained at 1998-levels, interest payments would be more than 11 billion higher than estimated in the budget, not a trifling sum. Total supplementary contributions of the Treasury to the Government Employees Pension Fund - made to reduce future commitments to the Fund – amount to close to 80 billion krónur including interest for the period 1995-2005. The position of the Fund has thus been strengthened accordingly and the need for direct payments of the Fund’s pensions out of the Treasury has thus been postponed for many years.

Mr. President

It is said that good words of wisdom are never too often repeated. In my previous budget speeches I have discussed the changes that have been brought about in the Iceland economy since 1991 which may be compared to a revolution. The objective of these changes has been to improve the economic environment of households and businesses so as to make them just as good or even better than prevails in our main trading partner countries. This should prevent people from moving to other countries in search of a better standard of living. The interference of the public sector in the economy has been greatly reduced and the powers of private enterprise have been allowed to flourish. Government enterprises have been sold and competition has been introduced in many areas previously subject to a monopoly. Most areas of economic activity have been liberalised. Personal and business taxes have been reduced. The list could go on and on. The result of these measures can clearly be seen in our flourishing economy. The purchasing power of households has been greatly increased. The recent changes in the housing markets, where favourable mortgage loans are being made available to the public, constitute an important improvement and are a direct result of this policy, particularly the privatisation of the commercial banks.

The changed organisation of economic activity has not only increased household income and improved the business environment but also created conditions for a changed emphasis in economic policy. It is now generally understood that a responsible fiscal policy and sound fiscal finances are prerequisites for a stable economy. The same applies to the importance of an independent monetary policy. These changes in the emphasis of economic management have contributed to a more stable economic environment and will undoubtedly facilitate that task in the future.

The improvements in fiscal finances have also made it possible to increase payments to old-age and disability pensioners, to education and culture, to roads, harbours and airfields as well as to social assistance, including unemployment compensation, and to aid for developing countries. A number of improvements in the social security system have been brought about in recent years. Payment entitlements have been increased and employment income curtailments have been reduced. Social security expenditures have doubled since 1998, or from 19.2 billion to 38 billion. Of this amount, disability payments have increased from 4.9 billion to 14.3 billion. The purchasing power of disability payments has increased sharply since 1998, or by 25.6 per cent for single disabled persons to those who are married or co-habit with a spouse that is not a pensioner.

The Government has made spending on education and research a priority. Appropriations for universities and research have increased sharply in recent years. This may be clearly seen in the budget where appropriations for education increase by close to 9 per cent from the estimate for this year. Expenditure on research continue to increase in accordance with the Government’s policy to strengthen funds for scientific research. Appropriations for the Research Fund under the Ministry of Education are thus increased by 85 million krónur to 500 million krónur and for the Technology Development Fund under the Ministry of Industry by 140 million krónur to 340 million krónur. The appropriation for a research fund used to increase the value of marine products is being doubled to 200 million krónur. Amongst OECD countries, Iceland ranks second after the United States in per capita public spending on research. Other member countries trail far behind.

With this budget, a final step is taken in a special measure to reduce waiting lists for services in communal living space for the disabled. A total of 200 million krónur is appropriated for this purpose of which 130 million krónur are earmarked for new living quarters for the disabled. In the health field, appropriations for the University Hospital increase by 500 million krónur and appropriations to other health institutions are also being increased. A total of 587 million krónur is earmarked for increasing the number of nursing home spaces. Next year, 55 new spaces will be introduced and 65 spaces in existence this year will be brought into year-around use. Furthermore, funds for day-time nursing care and short-term nursing home stays are also increasing. Appropriations for law enforcement increase by close to 200 million krónur of which 90 million are intended for a rapid reaction police unit and 55 million to increase the number of police officers in Reykjavík. Funds for district magistrates around the country to increase the number of police officers are also being increased. Finally, it should be mentioned that aid to developing countries increases by 500 million krónur and to the Icelandic peace-keeping force by 125 million krónur. Iceland’s aid to developing countries will thus have increased from 0.09 per cent of GDP in 1999 to 0.21 per cent in 2005.

There are some who have doubted that the Icelandic economy has changed as much as has been maintained here. The best indicators in this respect are to be found in comparisons with other countries. All international indicators confirm Iceland’s strong position in such comparisons. Economic growth is higher than elsewhere. Unemployment is far below the level in neighbouring countries. Fiscal finances are better and Treasury debt is lower. Inflation is on par with neighbouring countries, although at present it is close to its upper reference limit. When one looks ahead into the future, it emerges that our position is better than in most other countries. Our pension system is considerably stronger since it is fund-based to a large extent rather than being on a pay-as-you-go basis. This means that we need not resort to special measures in this country to meet the relative increase in the number of pensioners, whether through an increase in taxes or a cut in pension entitlements.

All of these factors have contributed towards improving living standards and a better competitive position of businesses in recent years. This has meant that Iceland offers one of the highest living standards in the world and one of the best places to run a business. This is generally agreed, as can be seen in the assessments of international agencies such as the IMF, the OECD and the three most respected credit rating agencies in the world that have placed Iceland in the group of countries that enjoy one of the best credit terms in international financial markets.

Mr. President

In closing, I wish to reiterate the main emphasis of the 2005 budget as well as that of the medium-term projection for fiscal finances that economic stability will be preserved over the next several years in spite of the increase in power project construction activity. This is due to the tight economic policy that has been laid down by the Government which it intends to pursue. This objective of this policy is to create a room for tax cuts and priority expenditures in accordance with the Government’s Policy Statement as I have already noted, without endangering the main objective of economic policy, that of maintaining stability.

I fully realise that it is neither simple nor popular to pursue such a policy at a time when the economy is growing rapidly. Although funds for road construction have been increased considerably in recent years, much remains to be done. And there are many other projects that people would undoubtedly like to spend money on. We are however in a position where we face very large investment projects which will test the very fabric of our small economy. In these circumstances, it is inevitable that the Government face up to the full weight of its economic management responsibility and do its utmost to ensure economic stability. This applies in particular to fiscal policy and monetary policy but I see it also as necessary that the local governments shoulder their responsibility since it is no less in their interest that stability be maintained.

I think it is therefore important that the debate on the fiscal budget and medium-term projection will centre upon the economic realities that we face. We can always disagree on the different degrees of emphasis and priorities. We should not have to dispute the overall framework of the economy and the need for a tight economic policy.

In direct continuation of these remarks I can not avoid commenting upon the misleading criticism of fiscal finances that has taken place in recent days where it has been maintained that all fiscal developments have gone awry in recent years and that the revenue balances in the final accounts have turned out to be 80 billion worse than fiscal budgets had assumed. This refers to a comparison on one hand of the budget revenue balances and the final figures according to the Treasury accounts. Is not that a fair comparison, some might ask? The answer is no. On the contrary, such a comparison is very misleading which can easily be explained.

First, it must be kept in mind that it is often necessary to react to unforeseen circumstances in supplementary budgets. All members of the Althingi have participated in the passage of supplementary budgets. Two such budgets were passed in 1993, the former was especially passed to increase spending on regional development and road construction and thus reduce the Treasury surplus.

Second, when measuring fiscal performance, certain items must be excluded that have no bearing upon the daily management of Treasury finances and are generally not clear until at the end of each fiscal year. This applies in particular to the expensing of pension fund commitments of government employees which have amounted to billions in recent years, up to 25 billion in a single year. These entries do not constitute cash payments out of the Treasury and have not impact on the economic management of the day. The same applies to tax claims written off.

Third, I wish to mention revenue from asset sales in excess of book value which also are accounted for as irregular items.

All of these factors must be held aside in order to get a realistic picture of fiscal developments. This has been distinctly pointed out in the notes to the Treasury accounts so that this should not come as a surprise to members of the Althingi. I do think therefore that it is not too much to ask that the honourable members get their sums straight. I also wish to note that all policy objectives of the Government in recent years have been formulated excluding these irregular items. The misleading and irresponsible statements of the media and certain members in these past days have not been to their credit. It is in fact remarkable that those who maintain that the fiscal budgets of recent years have been nothing but a shiny façade and that fiscal finances are in ruins can at the same time agree with the Government that there is considerable room for tax cuts. Such positions are incompatible.

I can name one single example of how ridiculous it is to use the Treasury accounts without exempting irregular items. In 1989, a non-recurring pension fund entry was expensed, amounting to 61 billion which is equivalent to about 120 billion at today’s prices. This led to a Treasury deficit for that year of 125 billion krónur. Although fiscal management was found lacking at that time, no one thought of including this entry in the discussion of the fiscal deficit.

And what is the actual result? If we take the Treasury accounts for 1998 to 2003 and adjust for irregular items, the surplus for these years amounts to a total of 95 billion krónur at current prices of each year, which works out to an average of 16 billion a year. The Treasury surplus was in fact 7 billion higher than had been assumed in the budget. This must be considered quite good, considering that during this period special measures were resorted to in order to improve the lot of the aged and the disabled in excess of fiscal budget appropriations. Measures were also taken to strengthen employment, such as in road construction. Finally, wage agreements were concluded in excess of budget assumptions. Such supplementary expenditure is always included in supplementary budgets in each instance. The conclusion from all this is that fiscal management has been sound throughout this period. This has been confirmed in the assessments of agencies such as the IMF and the OECD along with the world’s three most respected credit rating agencies as I mentioned earlier.

Mr. President

I wish to conclude my remarks by reiterating that the policy embedded in the fiscal budget and the Government’s medium-term projection shows that the Government is committed to a strong fiscal stance in order to counted the expansion in the economy. I am convinced that this is the right policy and that it will in the end yield the intended results. It will strengthen our country in relation to the international community and make Iceland a country with a desirable living standard and where businesses will wish to be located.

I propose, Mr. President, that upon conclusion of this debate, the fiscal budget be passed to a second reading and referred to the deliberation of the honourable fiscal budget committee. I look forward to a good co-operation with the committee and hope that the budget will be passed in accordance with the work schedule of the Althingi as in recent years.